When a company decides to offer to purchase outstanding shares, that’s known as a buyback. There are many reasons companies do this. It may be to increase the value of shares remaining through the simple law of supply and demand. It might be to take shares off the market, so a single shareholder can gain control of the company.
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Companies As Investors
A share buyback enables the company to invest in itself. If the company believes its shares are undervalued and decides to buy them back to provide investors a solid return that could make the company look strong to other potential investors. A buyback boosts the proportional share of earnings per share which, in turn, boost the value of the stock.
Some companies buy back shares to provide compensation to employees or manager to whom the company has promised stock rewards. Doing this (instead of issuing new shares) helps avoid dilution of the value of existing shares. On occasion, activist investors call for buybacks to help boost earnings when the company has not performed up to expectations.
Two Ways To Carry Out A Buyback
There are two basic ways a company can carry out a buyback. First, it can offer to buy shares from current shareholders at a premium. This compensates shareholders who give up their shares and agree to sell – perhaps before they want to.
The second way a company can execute a buyback is to simply buy shares on the open market over time at then current prices. Some companies even have a share buyback policy that calls for it to buy back shares at certain times or under certain market conditions.
Pros Of Stock Buybacks
As might be expected, share buybacks can produce both positive and negative results. On the plus side, a buyback can boost the price of shares as outlined above. This provides a short-term bonus for investors. Buybacks result in fewer shares trading on the public markets, which strengthens the share price.
Dividends can go up following a buyback if the company discovers that the number of outstanding shares has fallen enough that a boost in dividends is both warranted and possible.
Other potential pluses include better earnings per share, less excess cash in the company coffers (following a buyback) and, of course, a positive reputation for the company and better attitude on the part of investors.
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On the negative side, if the company buys back stock when value is high, the move can turn out to be a very poor use of capital. When a company spends a lot of money buying back shares it may have less to offer in quarterly dividends. If you count on those dividend checks to pay your bills, this could have a major negative impact on your finances. Investors often conclude that since share buybacks can be a poor use of capital, companies should concentrate on other ways to use spare cash. After all, every dollar used to buy back shares isn’t used to hire workers and build up the business. Share buybacks are often seen as a good thing for management but not for regular Mom and Pop investors. Finally, buybacks can be used to mask the issuing of lots of stock options to managers, a move that otherwise might result in price dilution.